FINANCIAL MARKETS QUESTION PAPER 1) a) What is the concept of Yield Curve? How can it be used as a "Crystal Ball" of economy?

Yield Curve A line that plots the interest rates, at a set point in time, of bonds h aving equal credit quality, but differing maturity dates. The most frequently re ported yield curve compares the three-month, two-year, five-year and 30-year U.S . Treasury debt. This yield curve is used as a benchmark for other debt in the m arket, such as mortgage rates or bank lending rates. The curve is also used to p redict changes in economic output and growth. The shape of the yield curve is closely scrutinized because it helps to give an idea of future interest rate change and economic activity. There are thr ee main types of yield curve shapes: normal, inverted and flat (or humped). A no rmal yield curve (pictured here) is one in which longer maturity bonds have a hi gher yield compared to shorter-term bonds due to the risks associated with time. An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields, which can be a sign of upcoming recession. A flat (or h umped) yield curve is one in which the shorter- and longer-term yields are very close to each other, which is also a predictor of an economic transition. The sl ope of the yield curve is also seen as important: the greater the slope, the gre ater the gap between short- and long-term rates. ECONOMY Since the 1980s, economists have argued that the slope of the yield curvethe spre ad between long- and short-term interest ratesis a good predictor of future econo mic activity. While much of the existing research has documented how consistentl y movements in the curve have signaled past recessions, considerably less attent ion has been paid to the use of the yield curve as a forecasting tool in real ti me. This analysis seeks to fill that gap by offering practical guidelines on how best to construct the yield curve indicator and to interpret the measure in rea l time. Before each of the last six recessions, short-term interest rates rose above lon g-term rates, reversing the customary pattern and producing what economists call a yield curve inversion. Thus, it is not surprising that the recent flattening of the yield curve has attracted the attention of the media and financial market s and prompted speculation about the possibility of a new downturn. Since the 19 80s, an extensive literature has developed in support of the yield curve as a re liable predictor of recessions and future economic activity more generally. Inde ed, studies have linked the slope of the yield curve to subsequent changes in GD P, consumption, industrial production, and investment. Whereas most earlier analysis has focused on documenting historical relationship s, the use of the yield curve as a forecasting device in real time raises a numb er of practical issues that have not been clearly settled in the scholarly liter ature. First, the lack of a single accepted explanation for the relationship bet ween the yield curve and recessions has led some observers to question whether t he yield curve can function practically as a leading indicator. If economists ca nnot agree on why the relationship exists, confidence in this indicator may be w eakened. Second, the literature lacks a standard approach to constructing foreca sts based on movements in the yield curve. How should the slope of the yield cur ve be defined? What measure of economic activity should be used to assess the yi eld curve's predictive power? The current variety of approaches to producing and interpreting yield curve forecasts may lead to misreadings of the signal in rea l time. This edition of Current Issues undertakes to shed light on some of the practical problems arising from the use of the yield curve as a forecasting tool. We begi n by considering whether there are explanations of the yield curve's predictive

power that would justify the operational use of this signal. We then discuss how best to construct the yield curve indicator and subsequently interpret the meas ure in real time. Our analysis offers specific guidelines on the choice of inter est rates used to calculate the spread, the definition of recessions used in the forecasts, and the strength and duration required of the yield curve signals. Conceptual Considerations The literature on the use of the yield curve to predict recessions has been pred ominantly empirical, documenting correlations rather than building theories to e xplain such correlations. This focus on the empirical may have created the unfor tunate impression that no good explanation for the relationship existsin other wo rds, that the relationship is a fluke. In fact, there is no shortage of reasonab le explanations, many of which date back to the early literature on this topic a nd have now been extended in various directions. For the most part, these explan ations are mutually compatible and, viewed in their totality, suggest that the r elationships between the yield curve and recessions are likely to be very robust indeed. We give two examples that emphasize monetary policy and investor expect ations, respectively.1 Monetary policy can influence the slope of the yield curve. A tightening of mone tary policy usually means a rise in short-term interest rates, typically intende d to lead to a reduction in inflationary pressures. When those pressures subside , it is expected that a policy easinglower rateswill follow. Whereas short-term in terest rates are relatively high as a result of the tightening, long-term rates tend to reflect longer term expectations and rise by less than short-term rates. The monetary tightening both slows down the economy and flattens (or even inver ts) the yield curve. Changes in investor expectations can also change the slope of the yield curve. C onsider that expectations of future short-term interest rates are related to fut ure real demand for credit and to future inflation. A rise in short-term interes t rates induced by monetary policy could be expected to lead to a future slowdow n in real economic activity and demand for credit, putting downward pressure on future real interest rates. At the same time, slowing activity may result in low er expected inflation, increasing the likelihood of a future easing in monetary policy. The expected declines in short-term rates would tend to reduce current l ong-term rates and flatten the yield curve. Clearly, this scenario is consistent with the observed correlation between the yield curve and recessions. The multiplicity of channels through which the predictive power of the yield cur ve may manifest itself makes it difficult to give one simple explanation for tha t power. However, it also suggests a certain robustness to the relationship betw een the yield curve and economic activity: if one channel is not in play at any one time, other channels may take up the slack. The conceptual relationships outlined here also have implications for the signal s provided by the yield curve indicator. First, the fact that long-term investor expectations figure so importantly in these relationships means that the yield curve may be more forward-looking than other leading indicators. In other words, the recession signals produced by the yield curve may come significantly in adv ance of those produced by other indicators.2 Second, the signals provided by the yield curve may be very sensitive to changes in financial market conditions. The precise effect of these changes on the yiel d curve will depend on whether they stem from technical factors or economic fund amentals. For example, because different maturities of fixed-income securities a ppeal to different clienteles, a permanent shift in the relative importance of c lienteles could produce permanent shifts in the slope of the yield curve. Altern atively, a temporary change in the demand for assets of a given maturitysay, a ch ange resulting from hedging activitiescould affect the slope of the yield curve f or a short time before the yield curve returns to values determined by economic fundamentals. These considerations suggest that the signals produced by the yiel d curve must show some degree of persistence if they are to be meaningful, an is sue to which we return below. Empirical Considerations To make the best possible use of the predictive power of the yield curve, it is

important to validate the predictive procedure historically and to apply it cons istently in real time. In this section, we consider the elements of one such app roach, a model in which a measure of the steepness of the yield curve is used to predict subsequent recessions. The Probability Model Empirically, we would like to construct a model that translates the steepness of the yield curve at the present time into a likelihood of a recession some time in the future. Thus, we need to identify three components: a measure of steepnes s, a definition of recession, and a model that connects the two. The approach we employ is a probit equation, which uses the normal distribution to convertin our a pplicationthe value of a measure of yield curve steepness into a probability of r ecession one year ahead. Details of this calculation are given in the box. The input to this calculation is the value of the term spread, that is, the diff erence between long- and short-term interest rates in month t. The output is the probability of a recession occurring in month t+12 from the viewpoint of inform ation available in month t. Both of these variables, however, need to be defined more preciselythat is, we need to specify what we mean by a recession and which long- and short-term interest rates we will use to produce the spread that const itutes our measure of steepness. Defining Recessions The standard dating of U.S. recessions derives from the cyclical peaks and troug hs identified by the National Bureau of Economic Research (NBER). To convert the NBER monthly dates into a monthly recession indicator, we classify as a recessi on every month between the peak and the subsequent trough, as well as the trough itself. The peak is not classified as a recession month because the economy wou ld have grown from the previous month. A similar rule may be applied to the NBER quarterly dates to derive a quarterly recession indicator. These conventions, w hile not the only possible ones, are the most frequently used in research on U.S . recessions.3 Measuring the Spread The interest rates used to compute the spread between long-term and short-term r ates vary across the literature on the yield curve's predictive power. For examp le, market analysts often choose to focus on the difference between the ten-year and two-year Treasury rates, while some academic researchers have favored the s pread between the ten-year Treasury rate and the federal funds rate. Other rates explored in the literature vary as to maturity, obligor, and computational basi s. In choosing the most appropriate rates, one should consider a number of crite ria, including the ready availability of historical data and consistency in the computation of rates over time. It is also important to consider the role of ris k premiums and coupons, although at present there is no standard way of dealing with these issues. The criteria cited allow us to rule out some interest rates as a measure of yiel d curve steepness. While a yield curve may be constructed from Eurodollar, swap, or corporate rates, all three have important drawbacks: comprehensive historica l data on the rates are lacking and the number of points they provide along the yield curve is limited. By contrast, Treasury rates readily meet our criteria for the yield curve indica tor. Data since the 1950s are available for several maturities, and are consiste ntly computed over the entire period. Treasury securities are also useful becaus e they are not subject to significant credit risk premiums that, at least in pri nciple, may change with maturity and over time. Pairing the long-term Treasury r ate with the federal funds rate as the short-term rate is a possibility, but whi le the spread between ten-year Treasuries and fed funds has been a very accurate predictor of U.S. recessions during some time periods, it has been less so in o thers. If Treasury rates are the best choice for our yield curve indicator, then we mus t next determine what maturity combination works most effectively. In forecasts of real activity, the most accurate results are obtained by taking the differenc e between two Treasury yields whose maturities are far apart. At the long end of the curve, the clear choice seems to be a ten-year rate, the longest maturity a

vailable in the United States on a consistent basis over a long sample period. W e use the ten-year constant maturity rate from the H.15 statistical release (Sele cted Interest Rates) issued by the Board of Governors of the Federal Reserve Syst em. With regard to the short-term rate, earlier research suggests that the three-mon th Treasury rate, when used in conjunction with the ten-year Treasury rate, prov ides a reasonable combination of accuracy and robustness in predicting U.S. rece ssions over long periods. Maximum accuracy and predictive power are obtained wit h the secondary market three-month rate expressed on a bond-equivalent basis,4 r ather than the constant maturity rate, which is interpolated from the daily yiel d curve for Treasury securities.5 Spreads based on any of the rates mentioned are highly correlated with one anoth er and may be used to predict recessions. Note, however, that the spreads may tu rn negativethat is, the yield curve may invertat different points and with differe nt frequencies. For instance, the ten-year minus two-year spread tends to turn n egative earlier and more frequently than the ten-year minus three-month spread, which is usually larger.6 Our preferred combination of Treasury rates proves very successful in predicting the recessions of recent decades. The monthly average spread between the ten-ye ar constant maturity rate and the three-month secondary market rate on a bond-eq uivalent basis has turned negative before each recession in the period from Janu ary 1968 to July 2006 (Chart 1). If we convert this spread into a probability of recession twelve months ahead using the probit model described earlier (estimat ed with Treasury data from January 1959 to December 2005), we can match the prob abilities with the recessions (Chart 2). The chart shows that the estimated prob ability of recession exceeded 30 percent in the case of each recession and range d as high as 98 percent in the 1981-82 recession. Level versus Change In addition to choosing the type and maturity of the rates used in the model, we must consider whether the probability of recession in twelve months' time is be st modeled in terms of interest rate levels or changes. The NBER defines a reces sion as a significant decline in economic activity spread across the economy, las ting more than a few months, normally visible in real GDP, real income, employme nt, industrial production, and wholesale-retail sales. The focus on a decline may s uggest that we should look at changes in leading indicatorsrather than levelsto as sess the health of the economy. In the case of the yield curve indicator, howeve r, the level of the term spread provides the most accurate signal of a forthcomi ng recession. One reason for the superiority of this measure is that, conceptual ly, the level of the spread already corresponds to a forward-looking expected ch ange in interest rates. Charts 3 and 4 allow us to compare the strength of the recession signals produce d by the level of the term spread and the change in the term spread. The charts show the statistical distribution of monthly observations of the two measures in 1968-2005, broken out by those observations that were followed by a recession m onth twelve months later (bottom panel) and those that were not (top panel). Consider first the distribution of the level of the spread (Chart 3). In the top panelmonthly observations that were not followed by a recession twelve months la terthe tallest bar shows that the value of the spread was between 2 and 3 percent age points in about 30 percent of the cases. In the bottom panel, the tallest ba r shows that when a recession did follow in twelve months, the level of the spre ad was between -1 and 0 percentage points in almost 50 percent of the cases. The noticeable difference between the distributions in the two panels provides clea r visual evidence that the level of the spread may be helpful in distinguishing instances in which a recession follows from instances in which a recession does not follow in twelve months. Now consider the distribution of the six-month change in the Treasury rate sprea d (Chart 4). We note at once that the distributions of monthly observations in t he top and bottom panels are much more similar here than in Chart 3. To be sure, the observations in the top panel are skewed to the right while observations in the bottom panel are slightly skewed toward more negative levelsa qualitative pa

ttern similar to that found in Chart 3. Nevertheless, it is clear that the abili ty to discriminate between recessionary and nonrecessionary instances is much mo re limited with changes than with levels. A simple example provides further evidence of the weakness of the change in the spread as an indicator. In May 1990, the average spread was 76 basis points. In June, it decreased by 27 basis points to 49. This decline resulted in an increas e of 7.1 percentage points in the implied probability of recession. By contrast, when the average spread decreased 27 basis points between January and February of 1993, from 3.54 to 3.27 percentage points, the implied probability of recessi on declined by less than 0.1 percentage point. These contrasting episodes sugges t that the change in the spread may provide an arbitrary signal, one that varies greatly with the steepness of the yield curve: in general, the steeper the yiel d curve, the smaller the impact of a given change on the implied probability of recession. Hence, the change in the spread by itself is not very informative. Interpreting the Signal Having established that tracking the level of the ten-year to three-month Treasu ry spread is useful in predicting recessions, we now consider how best to interp ret the signal sent by this measure. The lower panel of Chart 3 suggests that, o f the observations followed by a recession twelve months later, 69 percent (the sum of the bars to the left of zero) are negative. Thus, one could look to an in version of the yield curve as a signal. However, there still may be some questio n regarding the strength of the signal. Does the signal have to be persistent? H ow strong must it be? Does it matter if the inversion is driven by changes in th e long end or short end of the yield curve? The next two sections reveal that pe rsistent negative signals, no matter how slight, are reliable predictors and tha t the model does not depend on particular movements at the long end of the curve . Persistence and Strength Market chatter tends to pick up at the slightest sign of a yield curve inversion , regardless of size or duration, even intraday. However, inversions in daily or intraday data often prove to be false signals. Inversions observed over longer periodsat a monthly or quarterly average frequencyprovide more reliable signals. Consider, for example, that all six NBER recessions since 1968 have been precede d by at least three negative monthly average observations in the twelve months b efore the start of the recession (see table). Moreover, when inversion on a mont hly average basis is used as an indicator, there have been no false signals over this period. By contrast, negative spreads occurred on 100 days between January 1, 1968, and December 31, 2005, in months that did not turn out to have negativ e average monthly spreads. Although inversion has been a dependable recession signal in recent decades, the precise level of the negative spread has varied with each recession.7 The table shows the lowest monthly average level of the spread between ten-year and three -month Treasury rates in the twelve months preceding each recession since 1968. In this case, we look at the lowest level of the spread because it provides the strongest signal. Two clear features emerge from the table: the spread has alway s been negative (the yield curve has inverted at these maturities), and the leve l at which the spread has bottomed out differs considerably across recessionsfrom a low value of -3.51 to a slightly negative value of -0.08. We note, however, t hat while we focus here on predicting the occurrence and not the severity of rec essions, there is evidence that more pronounced inversionsas in the early 1980shav e generally been associated with deeper subsequent recessions.8 In sum, it seems most appropriate to look at the spread as a recession indicator on at least a monthly average basis. If the spread is calculated from ten-year and three-month bond-equivalent rates, an inversioneven a slight oneis a simple an d historically reliable benchmark. Short-End versus Long-End Changes Just as the strength of the inversion has no bearing on the ability of the model to predict a recession, so it is also immaterial how the inversion is influence d by changes at the long end of the yield curve. The performance of the yield sp read as an indicator does not seem to depend on the particular behavior of the l

ong-term rate in isolation. Monetary policy most directly influences the short end of the yield curve, altho ugh it may affect the level of long-term rates through expectations. An increase in short-term policy rates frequently results in higher longer term rates as we ll, though the rise at the long end is typically smaller. At times, the long rat es move in the opposite direction. Either case, if persistent, may result in an inversion of the yield curve. On occasion, long-term rates decline without a cle ar simultaneous movement in short-term rates, a pattern that may also result in an inversion. Chart 5 displays the level of the three-month Treasury rate (blue line) and the change in this rate over the eighteen months leading to peak recession signals s ince 1968 (green bars). The timing of the peak signals corresponds to the low mo nthly average spread levels reported in the table. We observe that the green bar s in the chart are all positive, indicating that a rise in the three-month rate preceded each recession during this period. In that sense, we could think of eve ry yield curve inversion as resulting at least partly from a rise at the short e nd. Chart 6 performs the same analysis for the ten-year Treasury rate, and we see th at its behavior is not as consistent as that of the short rate. Prior to the fir st four recessions, the long end of the yield curve rose as the yield spread sig nal was unfolding. Prior to the last two recessions, the long rate actually decl ined, contributing more directly to the yield curve inversion. The evidence from Chart 6 suggests that the performance of the yield curve as an indicator does not depend on the movements of the long-term rate. The inversion in 1981 was the most pronounced in this period. Contrary to what one might expe ct, the long rate did not decline but instead experienced its largest rise in an ticipation of the recession. Conversely, the last two inversions were accompanie d by declines in the long rate but were not particularly large in magnitude. Conclusions Our analysis suggests a number of practical guidelines for the use of the yield curve to predict recessions in real time: Defining recessions as the periods between NBER peaks and troughscounting the tro ughs but not the peaksproduces clear results. Treasury rates are most likely to produce accurate forecasts. The best maturity combination may be three months and ten years. Other choices l ead to results that are highly correlated with our own, but whatever combination is selected should be used consistently in both analysis and prediction. The three-month rate is best represented by the secondary market rate, expressed on a bond-equivalent basis to match the ten-year rate. The ten-year constant maturity rate produces good results. Levels of the spread are more informative than changes. As for why the yield curve is such a good predictor of recessions, we have revie wed a number of possible reasons, each of which may play an important role at di fferent times. The consistency with which these explanations relate a yield curv e flattening to slower real activity provides some assurance that the indicator is valid. Nevertheless, in the end, we must remind ourselves that the evidence o f the yield curve's predictive power is statistical and that, however accurate p ast signals have been, it is impossible to guarantee future results. OTHER ASPECT In finance, the yield curve is the relation between the interest rate (or cost o f borrowing) and the time to maturity of the debt for a given borrower in a give n currency. For example, the current U.S. dollar interest rates paid on U.S. Tre asury securities for various maturities are closely watched by many traders, and are commonly plotted on a graph such as the one on the right which is informall y called "the yield curve." More formal mathematical descriptions of this relati on are often called the term structure of interest rates. The yield of a debt instrument is the annualized percentage increase in the valu e of the investment. For instance, a bank account that pays an interest rate of 4% per year has a 4% yield. In general the percentage per year that can be earne d is dependent on the length of time that the money is invested. For example, a

bank may offer a "savings rate" higher than the normal checking account rate if the customer is prepared to leave money untouched for five years. Investing for a period of time t gives a yield Y(t). This function Y is called the yield curve, and it is often, but not always, an i ncreasing function of t. Yield curves are used by fixed income analysts, who ana lyze bonds and related securities, to understand conditions in financial markets and to seek trading opportunities. Economists use the curves to understand econ omic conditions. The yield curve function Y is actually only known with certainty for a few speci fic maturity dates, the other maturities are calculated by interpolation. The typical shape of the yield curve The British pound yield curve as of 9 February 2005. This curve is unusual in th at long-term rates are lower than short-term ones.Yield curves are usually upwar d sloping asymptotically; the longer the maturity, the higher the yield, with di minishing marginal growth. There are two common explanations for this phenomenon . First, it may be that the market is anticipating a rise in the risk-free rate. If investors hold off investing now, they may receive a better rate in the futu re. Therefore, under the arbitrage pricing theory, investors who are willing to lock their money in now need to be compensated for the anticipated rise in rates thus the higher interest rate on long-term investments. However, interest rates can fall just as they can rise. Another explanation is t hat longer maturities entail greater risks for the investor (i.e. the lender). R isk premium should be paid, since with longer maturities, more catastrophic even ts might occur that impact the investment. This explanation depends on the notio n that the economy faces more uncertainties in the distant future than in the ne ar term, and the risk of future adverse events (such as default and higher short -term interest rates) is higher than the chance of future positive events (such as lower short-term interest rates). This effect is referred to as the liquidity spread. If the market expects more volatility in the future, even if interest r ates are anticipated to decline, the increase in the risk premium can influence the spread and cause an increasing yield. The opposite situation short-term interest rates higher than long-term also can occur. For instance, in November 2004, the yield curve for UK Government bonds w as partially inverted. The yield for the 10 year bond stood at 4.68%, but only 4 .45% on the thirty year bond. The market's anticipation of falling interest rate s causes such incidents. Negative liquidity premiums can exist if long-term inve stors dominate the market, but the prevailing view is that a positive liquidity premium dominates, so only the anticipation of falling interest rates will cause an inverted yield curve. Strongly inverted yield curves have historically prece ded economic depressions. The yield curve may also be flat or hump-shaped, due to anticipated interest rat es being steady, or short-term volatility outweighing long-term volatility. Yield curves move on a daily basis, reflecting the market's reaction to news. A further "stylized fact" is that yield curves tend to move in parallel (i.e., the yield curve shifts up and down as interest rate levels rise and fall). <a href="http://www.webseoservices.in/seo-training-classes-india.htm" target="_b lank">SEO Training in Mumbai!</a> <a href="http://www.webseoservices.in/index.ht m" target="_blank">SEO Services!</a>